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Knology Inc. (NASDAQ:KNOL)

Q4 2008 Earnings Call

February 19, 2009 10:00 am ET]

Executives

Rodger L. Johnson - Chairman and Chief Executive Officer

M. Todd Holt – President

Bruce D. Herman - Chief Financial Officer

Bret McCants – Executive Vice President of Operations

Andrew Morrey - Cohen Asset Management

Analysts

David Joyce – Miller Tabak Co.

Frank Louthan – Raymond James

Jonathan Atkin - RBC Capital Market

Barry McCarver – Stephens, Inc.

Tavis McCourt - Morgan Keegan

Hamed Khorsand - BWS Financial

Amy Bloom – Stanfield

Operator

Please stand by, we’re about to begin. Good day everyone, and welcome to the Knology fourth quarter 2008 conference call. Today’s call is being recorded. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question-and-answer session, and now at this time, I’d like to introduce Bruce Herman, Chief Financial Officer. Please go ahead, sir.

Bruce D. Herman

Thanks you, Melissa. Good morning everyone, and welcome to the Knology conference call. With me this morning are Rodger Johnson, our Chairman of the board and CEO; Todd Holt, Knology’s President; and Bret McCants, our Executive Vice President of Operations.

Rodger will provide a state-of-the-business review, as well as cover some of the highlights of the fourth quarter. I will follow Rodger with a more detailed review of the quarterly operating and financial performance of the business and Todd will finish with some additional thoughts and provide some color regards how we are thinking about 2009.

Before Rodger gets started, let me offer a cautionary note regarding forward-looking statements. Some of the information we provide in discussing this call are forward-looking information and is given in reliance on a safe harbor provided by the Private Securities Litigation Reform Act. These forward-looking statements involve risks and uncertainties. Our actual results could differ materially from these forward-looking statements due to certain factors, including the risks and uncertainties discussed in Knology’s annual report on form 10-K for the fiscal year ended December 31st, 2007, as well as other reports subsequently filed with the Securities and Exchange Commission. With that, Rodger will provide an overview of our business.

Rodger L. Johnson

Thanks, Bruce, and thanks to everybody for joining us on the call this morning. I am happy to report that in spite of the economic big challenge in times our country is experiencing, Knology continue to show strong connection growth in the fourth quarter of 2008. We sold net additions of just over 8,000 RGUs during the quarter and our basic subscriber … grew by about 2,300. Our growth was distributed across all three product segments with high-speed internet leading the way. We ended the year with almost 677,000 net connections and passed the $400 million revenue mark for the first time in the history of Knology.

In the fourth quarter of 2008, we delivered our highest-ever revenue: $103.6 million and our highest-ever EBITDA: $35.2 million, and we’ve now increased revenues in EBITDA every quarter for 17 consecutive quarters. Our EBITDA margin expanded the 34% during the quarter and RPU was $51.11, compared to $49.17 in the fourth quarter of 2007. You should note that we saw a modest decline in RPU from the third quarter of 2008 to the fourth quarter of 2008, and what we believe is that consumers are purchasing the lower- end three-play and two-play bundles and are not locking in as many advanced products, premiums and DVR and HD as they have in the past, due to the little bit softer economy. There’s no doubt that we, like others, are seeing some slowing in the macroeconomic environment but in spite of this, in the fourth quarter, we saw revenues of 9-plus percent, our EBITDA up 18-plus percent and our free cash flow up 130-plus percent, as compared to the fourth quarter of 2007.

This performance was fueled by both organic growth and our 2008 acquisition of Graceba. The vast majority of our markets have been very resilient through these times, although as I mentioned last time, our two Florida markets: Pinellas County and Panama City are somewhat feeling the effects of the real estate … on their results. I’ve also mentioned on past calls about the Westpoint, Georgia market and some challenges that we placed there because of the decline in the textile market locally.

We are excited that now starting to get some firm service orders and contracts associated with the key automotive facility that is going to open here late in 2009, so that is really good news for the Westpoint marketplace. I think a very positive note for the fourth quarter of 2008 was that our turn levels were down sequentially from the third quarter of 2008 and also our full-year turn was down from 2007. We believe that consumers, particularly in the secondary and tertiary markets that we focus on, view cable and Internet services as high-value, lower cost sources of entertainment.

Additionally, we feel that the slow-down in new home construction has possibly had a bit of a stabilizing effect on turn. Similarly and maybe a little bit surprisingly, we have not, and I repeat, we have not seen any up ticking bad debt thus far and that is a good thing. The combination of better turn performance with the previously-mentioned strong RGU growth drove our overall RGU penetration at the end of the quarter up to 73.6%. That is a full half or five-tenth of a percent increase versus the third quarter of 2008, in light of the penetration that we had then.

Among our significant accomplishments in the fourth quarter was the conversion of our required Prairie Wave markets, both Sioux Falls and Rapid City to our Usha enterprise management and billing system. Our conversion went well, and should facilitate better realization of the remaining synergies possible from the combination of our companies.

We would have liked to have completed this conversion a bit earlier, but we encountered some database mapping issues and decided to wait until we could minimize any customer or organizational impact before converting. I might add that with both Prairie Wave and Graceba acquisitions, the integrations have gone well and have provided really solid operating synergies for Knology.

Our business and commercial sales efforts were highlighted during the fourth quarter by the increased traction that we are gaining with our Iplex product. You might recall that we announced a SIP trunking offering or a SIP trunking product in the second quarter and it has been well received in the marketplace. Our business customers seem to like the flexibility that SIP trunking provides relative to the scaling of their network needs, as well as the cost advantages that it affords. This has been a great solution for our rapidly-expanding business data delivery requirements and we have actually now held launch events in most of our markets and received great visibility in the local business communities in each market. We are optimistic about future sales. As a matter of fact, I know of at least one market that had over a hundred businesses show up at our launch program.

On a little bit of a different front, some of you who have followed Knology for a while will remember that about two years ago, we decided that we would offer contracted VoIP services on a low-key selected basis to some small communications firms operating in our geographic regions. While this does not deliver incremental RGUs, it does offer incremental revenue and EBIDTA at attractive margins, and we have begun to pick up a little momentum in this area.

We’re now delivering contracted VoIP services to over 2,000 subscribers through three different relationships that we have and we will be bringing a full, small communications firm online over the next few months. This complements our least cost-routing program and our IP provisioning and rating products that we delivered through our provider-solutions group.

I think another item worth mentioning from the fourth quarter is that we completed a good deal of the engineering and design work to allow us to begin construction associations with our fill-in strategy which we discussed on our last call. This is going to allow for focused, high-return growth in our existing markets in 2009. We are very excited about this program as are the communities where we operate. We have actually already started construction in some markets and I think Todd is going to give you a little bit more color during his comments later on in the call.

We completed the vast majority of our VOD build out during the fourth quarter of 2008 and are delivering VOD in all but a couple of our markets now. Our 2009 planned HD additions are still tracking toward a timely implementation and lastly, we are continuing to enable our markets for the DOS 3.0 deployment. As we have said before, our DOS plans were spread out throughout 2008, 2009, and 2010. We are already actively deploying upgraded CNTSs throughout our network for this and for those of you who are not familiar with DOS 3.0, its deployment will allow us to substantially increase speeds for our high-speed internet customers. We are going to actually implement DOS 3.0 on a market-by-market basis as the competitive situation dictates.

I guess about the only downer that I can offer up for the fourth quarter is that we had to contend with the negotiations for retransmission fees. We worked very well with our network affiliates through the process by taking a proactive approach and we went to them long before the expiration of our existing agreements. We felt like we generally reached fair agreements with these folks, but at the end of the day, we are still going to be paying about $3.4 million for retransmission fees in 2009 that we have heretofore not had to contend with, so that factors is in our cost services going forward.

As I wrap up, we are going to particularly emphasize strong net connection growth early in 2009. Promotions and marketing investments led to solid results in the third and fourth quarters of 2008 and this momentum has continued thus far in 2009 and we are currently enjoying a comfortable backlog of installs that has positioned us very well. We may sacrifice a little on the near-term magnitude of our EBIDTA growth with this marketing and promo commitment, but we feel positive about the medium in long-term value-added strategy.

I guess the facts that summarize our touch points for 2009 are: 1) Maintain a healthy balance sheet and continue to generate cash which Bruce and Todd are going to address 2) Insure that we adhere to our planned cost-control measures 3) Make a prudent but not overly aggressive investment in our future. With that, I will turn the ball over to Bruce.

Bruce D. Herman

Thanks, Rodger. We provided large statistics in our early release that was issued earlier this morning and I will summarize the highlights over the next few minutes. Let me begin by reviewing the operating matrix. We ended the fourth quarter with nearly 677,000 total connections, a 5.7% year-over-year increase reflecting solid growth in both residential and business markets. Residential connections increased by 3.8% from a year ago, reflecting the strong marketing, and promotional efforts in the second half of the year. Remember on earlier calls, we described how we suspended our marketing and promotional efforts during the first half of 2008 while we evaluated the impacts of our 2007 promotional activity. Business connections continued to show encouraging momentum, increasing by 17.6% from a year ago.

We have over 101,000 business connections and they account for about 15% of the company’s total connections and approximately 20% of total revenue. Connections grew 8,001 units during the fourth quarter, with increases in all services. We had a 4,684-unit increase in our high-speed internet connections, a 2,372-unit increase in video connections, and a 945-unit increase in voice connections. In additions to these solid fourth quarter results, we are encouraged by continued positive momentum in January and so far in February in both the residential and commercial markets.

Turning to average revenue per connection, or RPU, our overall RPU was $51.11 in the fourth quarter. Although it was down slightly from the third quarter, we experienced a nice increase from $49.17 a year ago. RPUs for the three services were $61.52 for video, $45.07 for voice and $40.70 for high-speed internet. Average revenue per customer was $121.89 in the fourth quarter, up from $115.80 a year ago. These RPUs were slightly lower than last quarter, as Rodger mentioned, due generally to the softness in economy, with less demand for the advanced services, but we still view them as overall healthy levels.

These RPU figures reflect price increases early in the year, continued growth in our commercial business, continued growth in our bundled services, as 82% of our residential customers now take two or three product bundles and our continued consumer demand for the high-end video services. 47% of our cable customers take a digital offering and of those, 61% take an advanced set top box that provides HD and/or DVR capabilities.

A year ago, only 47% of digital customers had advanced set top boxes. We are also encouraged that average monthly connection turn has remained in check - also as Rodger mentioned - in this tough economic environment. Turn was 2.4% in the fourth quarter, down from 2.5% a year ago and down from 2.8% in the third quarter.

Now I will point out that the turn is seasonal in our business and our first and fourth quarters tend to be lower-turn periods than the second and third quarters but there are several reasons for the stable turn numbers. First, we have not seen a deterioration in turn caused by non-paying customers; a trend we monitor closely especially in the current economy. Second, people are not moving as actively as they normally do in a healthy housing market. Third, those 82% of our residential customers that take multiple bundles tend to be more loyal than customers that take only one service. Finally, we have a growing base of business customers who generally or under contract in turn less than residential customers. These factors, along with our company-wide focus on providing a great customer experience lead to the favorable customer retention.

Moving on to the financial performance, our revenue was $103.6 million for the fourth quarter, representing a 9.3% increase compared to the fourth quarter last year, and a sequential increase from $103.2 million in the third quarter of 2008. Total revenue for the year was $410.2 million, up 18% from 2007. EBITDA for the fourth quarter was $35.2 million and 18.2% increase compared to the same period last year, and a sequential increase from $34.6 million in the third quarter. Our EBIDTA margin increased to 34% this quarter, up from the 31.5% margin posted in the same period one-year ago and 33.5% last quarter. EBIDTA for the year was $136.6 million; a $30.2 million or 28.4% increase from 2007 and reflects a healthy 48% of EBIDTA flow-turn in 2008. GAAP operating income includes non-cash expenses and it was a positive $9.6 million for the quarter, up $4.9 million or 105% from a year ago. For the full year, GAAP operating income was $34.8 million; up $18.5 million or 114%.

Moving to the net income line, we experienced the net loss of $2.1 million or 6 cents per share in the fourth quarter, an improvement from the net loss of $2.8 million or 8 cents per share in the third quarter. For the year, we had a net loss of $12.1 million or 34 cents per share, an improvement from a net loss of $43.9 million or $1.25 per share in 2007. Our earnings release goes into more detail about the impacts of a loss on extinguishing debt and a gain on selling a non-core business from 2007. Excluding those items, the net loss in 2007 was $24.8 million or 71 cents a share.

Levered free cash flow continued to be strong at $15.3 million in the fourth quarter and $45.2 million for the full year or $1.27 per share. Recall that we quote our free cash flow on a levered basis after recognizing net cash interest costs. The $45.2 million levered free cash flow for the year was $16.9 million or 60% higher than in 2007. On the balance sheet, we ended the fourth quarter with $58 million in cash, up $11.3 million from the cash balance at the end of the third quarter. In addition to the cash on hand, we also maintain a $25 million revolver, none of which is currently draw, and so it continues to serve as liquidity cushion for the business.

From a leverage perspective, we are at 4.3 times LQA EBIDTA using gross debt and the same calculation on a net debt basis or net of cash yields a leverage ratio of 3.9 times, and I would point out that our net leverage has now gone below the four times multiple threshold. Our interest coverage is at 3.2 times, so we feel very good about where we are from a balance sheet liquidity and a leverage perspective.

Our capitalized expenditures came in at $9 million for the quarter and at $47.5 million for the year, as we continued to monitor our spending closely. About 70% of our capital spending is success-based, meaning it quickly generates incremental revenue. The remaining capital expenditures are network improvements and maintenance costs.

In summary, the fourth quarter was a good quarter with continued growth and financial momentum. As Rodger indicated, early 2009 activity is very promising and we are looking forward to another good year in 2009. Todd has a few more comments to add before we open the call for questions and answers.

M. Todd Hold

Thanks, Bruce. I wanted to briefly cover a couple of things. First, regarding our bank debt: you have heard us speak about the excess cash flow sweep requirement as part of our credit facility. As a reminder, we are required to make a mandatory principal payment at far equal to 50% of our excess cash flow for the calendar year. Excess cash flow is defined in our credit facility as different from our free cash flow calculation. As you know, our free cash flow definition is EBIDTA, less capitalized expenditures, less net cash interest.

As Bruce provided earlier, our free cash flow was a healthy $45.2 million in 2008. The excess cash flow as defined in the credit facility requires other subtractions from EBIDTA, including any principal payment and any investments for permitted acquisitions so the cash used to fund the Graceba acquisition in early 2008 is also deducted in the credit facility excess cash flow number.

Where we end up from a credit facility perspective is about $17.8 million of excess cash flow for the year. The 50% payment is due no later than 95 days after year-end. We decided to go ahead and make the payment early to … a little more cash flow resulting from lower interest, so we made the $8.9 million principal payment at the end of January to go ahead and get this done.

A couple of other points about our bank debt, of which we are getting questions these days, are the maturity date in the covenants. I thought it would be helpful to take a minute to address these. On the maturity date, our bank debt matures on June 30th, 2012 - more than three years away. We will be chipping away at the outstanding balance with the normal amortization, along with some sizeable excess free cash sweep payments as we approach the maturity date. This along with growing EBIDTA will have a sizeable impact on the leverage ratio from where we are today to mid-2012.

Regarding the covenants, Bruce noted our leverage ratio and interest coverage a moment ago. These two ratios along with CapEx are the only financial covenants in our credit facility. We currently have over 30% cushion on both the leverage and interest coverage numbers. Based on the schedule changes in these covenants -ratios in the facility- we believe there will be good cushion all the way through maturity.

On the CapEx front, we do not see any limitation from the credit facility standpoint to keep us from making the necessary investments to keep the business moving forward. Finally, I will provide some color as to our expectations for 2009. As you probably expect, and consistent with what many companies are doing these days, formal detailed guidance is difficult to provide given the current uncertainty in the economy. We are fortunate to run a business that continues to grow and deliver significant free cash flow in this environment. Although our broad profile will slow from the previous couple of years, given the creative impact of the Prairie Wave and Graceba acquisitions that are now behind us, we do believe that the business can deliver solid organic growth in 2009.

We should experience growth across the board: connections, revenue, EBIDTA, and free cash flow. Additionally, we will see capital expenditures increase from the 2008 levels. We realize the higher CapEx made bucked the trend in today’s market but we have a unique opportunity to invest in some high ROI fill-in expansion. I am sure many of you on the last call heard us talk about the fill-in experiment in our … market in 2008.

Just the recap, we spent $250,000 to build paths to approximately fourth homes. These homes were already being served by the incumbent cable company or satellite provider. After 90 days from the completion of construction activity, we were above 80% RGU penetrated and today, we are north of 93% RGU penetrated. Also, the RGU and bundled nature of these customers are very impressive. This all results in some pretty nice results, high EBIDTA margins and high EBIDTA flow-through, generating ROIs in the 50% or even higher range.

With the market conditions where they are today and the M&A market closed, we believe that the next best investment to a creative M&A are these high ROI fill-in opportunities, so in 2009 we planned to invest approximately $6.5 million to very selectively and opportunistically expand the network to these attractive areas where we already have all of the head-in and operational infrastructure in place.

Our CapEx over the year will increase about $8 million, with $6.5 million of the $8 million increase coming from these fill-n investments. Also, we are making some network enhancements in 2009: things like continuing to move forward with some DOS 3.0 investment and adding more HD channels to our line-up in order to maintain a competitive position in the marketplace.

What all of this means in terms of 2009 free cash flow is, excluding the fill-in investment, we believe that the business can achieve free cash flow growth of about 20% in 2009 and, even after layering in the $6.5 million fill-in CapEx, we expect to see free cash flow increase in the 7-8% range. The point is: that even with higher CapEx investment in 2009, which is driven primarily by the fill-in strategy, we believe that this business will still deliver higher free cash flow in 2009 and more importantly, we believe that it will position the company to deliver higher free cash flow over a longer-term period.

Just to sum things up before addressing your questions: we certainly acknowledge that times are tough out there and there has been, and there will continue to be, an impact on our business. However, with $58 million of cash on the balance sheet at year-end, us having a focus on operating in these more stable secondary and tertiary markets and the business being in a position to grow organically, while continuing to deliver very strong free cash flow, we just would not want to trade places with very many people these days. We continue to be excited about our business and look forward to the coming quarters.

Melissa, this concludes our prepared remarks this morning. We would now like to open the line for questions.

Question and Answer Session

Operator

Thank you, the question-and-answer session will be conducted electronically. [Operator instructions] We will take our first question from David Joyce from Miller Tabak and company.

David Joyce – Miller Tabak Co.

Thank you, very nice residential and RGU growth. Just to focus on the negatives, some market likes to do that. We were expecting positive commercial RGU growth; it looks like you backed off about 2000. Is that the case or is that related to some other Prairie Wave building system integration?

Rodger L. Johnson

David, that was totally related to the Prairie Wave integration. We have done these integrations now like 8 or 10 times over the years and invariably, we will find that these things are not classified according to our policy and what have you, and there were some RGUs that were classified as business that should have been classified as residential, so that’s what the deal was there.

David Joyce – Miller Tabak Co.

I think that’s it. I just had the question on whether the decrease in CapEx in the fourth quarter was recurring or was that just a seasonal thing, but it seems like with your investments in DOS 3.0 in the markets, the pace will be back up.

Unidentified Company Representative

The way it typically works with our CapEx spending and if you look back at the past several years, you’ll see that we normally have higher CapEx spending in the first half of the year and then it tapers down in the second half of the year. It’s what we will see in 2009 as well and (I think it was) during the second quarter, we had commented to that type of pattern; just more upfront CapEx and then slowing down to end out the year.

David Joyce – Miller Tabak Co.

Great, good quarter, thank you.

Unidentified Company Representative

Thanks.

Operator

We’ll take our next question from Frank Louthan from Raymond James.

Frank Louthan – Raymond James

Great, thank you. Can you us a little more color on the promotional activity; some of the timing? Did you serve some of those customers more later towards the quarter and does that explain the RPU impact? Give us an update on what you have seen on the trends. I know that on the second quarter, you announced your teams are pretty positive; retention trends with promotions that you have done that further alarm some of those customers. Has that remained the trend or you are still seeing pretty significant retention after the customers come off their initial promotional contracts things?

Rodger L. Johnson

Let me comment on the retention part of it first and I think we are still seeing the same kind of patterns that we reflected to you. I have got to the point now where I do not look at it every month like I used to because the retention pattern off of the promos and the marketing investment has kind of lined up pretty consistent with our normal retention pattern right now, as far as just moves and normal turn process that we run through so we are not seeing anything abnormal. Actually, one of the reasons, Frank, that we have made the marketing investment and the promo investment is having seen such stability with a retention by going ahead and getting the customers signed up early in the year and tail end, last year. We get the benefit of carrying those customers for 12 months during the course of the year, so I think that it is the right strategy for us to have. The answer, Bret, on the RGUs: did we see them sign up later during the quarter from a fourth quarter standpoint?

Bret McCants – Executive Vice President of Operations

We got pretty even growth, but you factor in the number of working days given all the days in November and December. We saw a good steady growth in that fourth quarter.

Rodger L. Johnson

I think you got to factor in what we normally see in holidays and things like that. From the ones you sign up in the first month of a quarter, you do not get any revenue or benefit to speak out from those, and then you start to get it in the next quarter and if it is billed over the quarter, you get a little bit more, so it’s a little bit back in loaded when you do grow like that.

Frank Louthan – Raymond James

Great, and then on a competitive front, are any BMSOs rolling out DOS 3.0 in any of your markets? I assume that there’s going to be a follow strategy on that but can you give us an update on … from AT&T and Verizon down in Saint Pete: any changes there?

Unidentified Company Representative

Bret, any thoughts on that?

Bret McCants – Executive Vice President of Operations

We’re not seeing DOS 3.0 or speeds that are competitive with ours in any of our markets. We do see some activity increase speeds in the Pinellas market with the … and all the attention that is given down there, and then the other part of that: obviously, you would expect that based on what we said in the past out of [fios].

The other part of your question was new verse and we haven’t really been seeing anything meaningful from a new verse standpoint in the markets that we operate in and, like Todd said, we are kind of bucking the trend a little bit by investing in our growth and a lot of the other folks are kind of pulling in their horns right now. We feel pretty comfortable with what our cash position is and like I said, on a very selective and prudent and not aggressive basis, we want to take this opportunity to grow competitively with those guys, as long as they don't have the products in the marketplace. If you look at the numbers, we are taking share away from the MSOs.

Frank Louthan – Raymond James

Great, thanks a lot.

Operator

We will take our next question from Barry McCarver, with Stephens, Inc.

Barry McCarver – Stephens, Inc.

Good morning, guys, and good quarter.

Bret McCants

Thank you, Barry.

Barry McCarver – Stephens, Inc.

I have a couple of questions. First off, just a little housekeeping to make sure I understand the math going on with the units. Did you guys physically add 8,000 new units for the quarter, or is some of that reclassification?

Bret McCants

That physically added 8,000 new units.

Barry McCarver – Stephens, Inc.

And if I put the numbers in right, it looks like a lot of that came surprisingly, in the voice side. Number one, am I right there and number two, just a little bit more color on what was driving that during 4Q.

Unidentified Company Representative

We actually had about 945 units added to the voice; that is part of the 8,000 units in the quarter, here. We were fortunate seeing it, not only on the business side, but a little bit on the residential side too, that it was just a favorable trend and certainly counter to a lot of the voice declines that you see in some of the other markets. I think that is a reflection as we added units and customers, that people take the double and triple bundle with us, and it provides us an advantage that some of the other MSOs or providers are not as penetrated.

Bret McCants

I think we get the voice – in all fairness, we see some pressure on the voice side, just like everybody else does, with this wireless replacement and what have you, Barry. When people are picking up the triple play, that voice add kind of gets carried through that triple play product. We have priced it in a way that is very attractive for them to do the triple play. If they are going to do multiple services, they might as well get the triple play versus topping out at the double play.

Barry McCarver – Stephens, Inc.

Did you see any benefit from the transition to digital T.V? I know it got pushed back but it got pushed back the last minute. Are you seeing some benefit from that in your market?

Bret McCants

We really don't think that is really pushing the envelope for us; the digital T.V. transition – I can of sense it as the people who were kind of down at that end of the spectrum were down there for a reason. They are more than likely to go user coupons and buy boxes as opposed to upgrade. We might see a little bit, but honestly, we're not factoring that into our thinking or our growth prospects, whatsoever. If we get some, we will be happy to take it but we just don't see anything meaningful there.

Barry McCarver – Stephens, Inc.

Okay, and my last question, kind of a bigger picture question. In thinking about this additional investment in the fill ins, did you look at other uses of free cash flow? I was kind of wondering your thoughts there about more pay down, stock buyback, or anything else you might use some of that free cash flow for.

Unidentified Company Representative

Barry, the credit facility doesn't allow us to pay cash dividends or do stock buy backs, so those are off the table. Quite frankly, when we can invest money and earn 40%, 50%, or even better ROI, we typically, in this environment, we have no problem with the extra liquidity and the dry powder to make investments when the alternative is really just paying down 7% cost of debt. For the time being, we are going to generate this healthy free cash flow. We will let some of it pile up on the balance sheet, as we said earlier; we are going to be very selective in the fill in investment. We don't feel like we are being very aggressive there, $6.5 million dollars, with high ROI. We feel very comfortable there.

Barry McCarver – Stephens, Inc.

What kind of revenue, organically, do you think you can produce with that investment? Is this something we can see mid-single to maybe low double-digit revenue growth, this year?

Unidentified Company Representative

We believe this is going to top out at around a $2 millionish. The investment that we are looking at, right now, would be around a $2 millionish run rate. Again, that has to build up through the years. You're not going to see it all hit in 2009. The run rate will get us to around $2 million in revenue.

Barry McCarver – Stephens, Inc.

All right, guys, thank you.

Operator

We will take our next question from Jonathan Atkin, from RBC Capital Market

Jonathan Atkin - RBC Capital Market

Good morning. On the fill in investments, could you give us a flavor for how many quarters, months, or what not, that it takes you to reach free cash positive, positive cash on cash returns, on that investment? Based on Todd's comments, it sounds like that has been residential focus. I wonder, to what degree going forward, the fill in is going to be mostly into neighborhoods, or is there going to be a significant commercial exposure for that? Then, I have a follow up.

Rodger L. Johnson

Jonathan, we are really excited about the fill ins. You have heard us talk about the ROI so you know we are talking 50% type of ROI. If you look at that on a cash-on-cash payback, you are looking at a three to four year-type payback period. The focus going into the fill in investment is the residential areas because we can cherry pick areas; we know where the competition is. These areas are going to have an incumbent cable company and satellite, but we know areas where our penetration rates are very high and our RPUs are very high, and the EBIDTA economics are going to be solid. We can just selectively pick those spots. What that will mean is that there is going to be new network in that area and that certainly can bleed over into opportunities on the small business side. Down here in our neck of the woods, there are strip centers and businesses all over the city. There certainly ought to be some ancillary opportunities to drive some business growth, from the fill in investment, as well.

Jonathan Atkin - RBC Capital Market

In terms of economic head winds and impacts on your business, I guess I have two questions; which of the RG product categories has the highest degree of charm. Where do you see, in which product category do you think there would be the highest activity, in terms of down-tiering to a lower package, whether it's voice, video, data, or what not?

Unidentified Company Representative

I think the product line that is faced, right now, with the most pressure – and I don't know if this is the right way to answer your question, is clearly the telephony product. We tend to look at it based on the triple plays and the double plays and the single plays. The ones I think are the churn is coming from, are the ala carte one-offs, the cable-only guys, or the voice-only guys, or to a lesser extent, to the data-only guys. That is where we are seeing it. The single play folks, whatever service they happen to have, is where we are seeing the most churn.

Jonathan Atkin - RBC Capital Market

Thank you very much.

Rodger L. Johnson

One other comment, Jonathan – for everybody's benefit, you had the question about the fill in things. Bret, I think we are targeting, right, now, about 8,000 marketable passings, as a result of that investment. Is that correct?

Bret McCants

About 8,000 homes, I like to refer to, because when we do our fill in strategy we are looking for areas that are built-out, not empty lots. We will be passing approximately 8,000 homes, roughly, Roger, 3,000 in Q1, 3,000 in Q2, and about 2,000 in Q3.

Rodger L. Johnson

The other point that I wanted to make is; you were talking about picking up businesses. We still have the same investment plan, next year, that we have had the last year or two, in what we call CIU, Commercial and Industrial Unit expansion. We are still going to invest on a case-by-case basis, when we see these business opportunities. We are going to put them through that part process, that we always use, that says if we find something that can deliver a 40% IRR, we will consider making that capital investment, at the same levels we have done for the last two or three years.

Jonathan Atkin - RBC Capital Market

On the commercial side, then, I am assuming that in most cases, you are displacing the incumbent telco; yet, you are not by any means the first … to appear in front of these businesses. What is it that is driving your success and what do you see going on with other CLECs that you may overlap with?

Unidentified Company Representative

First, one of the things we are proud of is we have a local presence. That is huge for the SME business segment. Also, we offer competitive and very important facility-based service offering, as opposed to some of the CLEC, which may be leasing AT&T facilities or Verizon facilities. It is reliability; it's a local field; I can call my business field reps in my market and reach a live human being. All those contribute the growth in the SME market.

Rodger L. Johnson

Plus, I think two other things are the product line. We have the SIP trunking product, this Session Initiated Protocol, that is a very flexible, dynamic, and desirable product. In many instances, our competitors are not offering it in our market places. You have heard us say before, we have been in the IP business, for business customers, for five, or six years now, with products like Matrix, which is the IP-based Cintrix product. They basically have a virtual PBX that they can subscribe to from Knology. We fundamentally, not only did we do what Bret said; we provide high quality service and we have a strong local presence. We also have some products that are just not out there in the hands of the competitors, right now.

Jonathan Atkin - RBC Capital Market

Thank you.

Operator

We will take a quick question from Tavis McCourt, with Morgan Keegan

Tavis McCourt - Morgan Keegan

Thanks, I just have a couple of quick questions. First, on the Q4 numbers, it looked like there was a pretty big jump in the "other revenue". What that related to the billing conversion as well, and can you talk about what that was, and how much of it is non-recurring? Then, also, the voice revenues look like they were down, sequentially. I think this is normally a seasonally up quarter in your ILEC business. I was wondering if that was also billing conversion related?

Unidentified Company Representative

I don't think it is billing or conversion rate related in any kind of way. The ILEC revenues, we have continued to face the challenges in the ILEC environment, particularly down here in the Westpoint area because of the textile shutdowns and I think Chambers County, Alabama had 14% unemployment in the aftermath of all that. As I said a while ago, we are starting to get these KIA orders coming in, in the first quarter of this year, so we are optimistic about that.

I just think it was economic pressure in these environments, plus that is where you tend to have more of your single line customers, in the ILEC environments, as opposed to in our broadband market places. I think that is the answer to that side of the question, Tavis.

On the other revenue, that is where we are starting to see the benefit of some of those things as I talked about a while ago, the contracted VoIP services that are starting to buildup over time. We had a couple of dark fiber sales. I think, for the whole year, our dark fiber sales were like $1.7 million. It is still a relatively opportunistic sale that we made. We had a little bit of that that wove in there, as well, Tavis.

Tavis McCourt - Morgan Keegan

Great, and a couple of housekeeping items. You mentioned that the total bundle percentage was 82% for residential. Can you split that out between the double play and triple play?

Unidentified Company Representative

It was about 51% triple play, and the remainder was double play.

Tavis McCourt - Morgan Keegan

What was the GAAP operating cash flow for the quarter?

Unidentified Company Representative

Yes, the GAAP cash flow, provided by operations for the year, is going to end up at about $80 million. What that will mean is that for Q4, it is about $22.1 million.

Tavis McCourt - Morgan Keegan

In trying to parse out the CapEx a little bit, the $9 million you did for this quarter; is that kind of a reasonable estimate for what you guys are doing, largely, just set top box wise at this point, or did even that $9 million include some network build?

Unidentified Company Representative

It was CP as well as CIU business line extensions, just the normal 4th quarter activity.

Tavis McCourt - Morgan Keegan

Okay.

Unidentified Company Representative

We are still putting some of the CMTS upgrades in, as Bret said, just kind of the normal success-based activity as well as network related activity.

Tavis McCourt - Morgan Keegan

Great, thank a lot.

Operator

We will take our next question from Hamed Khorsand, with BWS Financial

Hamed Khorsand - BWS Financial

Good morning, guys. I am just trying to get an understanding about gross margins. As you see, the churn to stabilize here is around the 2.4% mark, you see less subscribers taking on the HD and DVR based subscriptions. How does that affect your gross margin over an annual perspective, not just a quarterly number?

Unidentified Company Representative

When you are running 70% type of gross margins, which are extremely high, obviously, because we are a facilitaties-based business. We have those very high gross margins. In an environment like today, and given the comment that Rodger made early on, about retrains on the programming cost side, going into 2009, there is a little pressure on gross margins. There should not be expectations that that gross margin increases significantly, from where it is. There is a little pressure on gross margin, just with some softness and HD, DVR, advanced applications that we talked about earlier, and retrans, a little bit there. We will continue to post very high gross margins and solid flow through, down the EBIDTA line. We will keep our eye on the SGNA as well.

Hamed Khorsand - BWS Financial

I was going to ask a follow up on that; the SGNA line, before the [Graceba] acquisition you were doing, around $37 million or so, $38 million; you are now in the $39 million to $40 million. Is there any intention of bringing it back down to that $37 million to 38 million line, or should we assume that it will be a constant rate between $39 million to $40 million?

Unidentified Company Representative

I think it will probably be a constant rate. There is 'x' amount of SGNA associated with the [Graceba] operations, all the normal sales commissions and truck rolls, and all that kind of stuff, that incremental piece of business.

Hamed Khorsand - BWS Financial

What I am trying to understand is how we can assume that EBIDTA margin can expand when gross margin is declining and SGNA is going to be at a constant rate.

Unidentified Company Representative

Revenue will grow; gross margins – when you say that will decline, there is no significant deterioration in gross margins. Gross margins will stay pretty stable. You have revenue growth, fairly stable gross margins, with the SGNA held in check. We will still experience solid flow through down to the EBIDTA lines. It is not going to be the 70% type flow through of two years ago, but we are still going to be in the 40% or better type flow through from revenue growth all the way to EBIDTA. That will be accretive to the existing EBIDTA margin, which ought to allow us to continue to see that EBIDTA margin slightly increase.

Hamed Khorsand - BWS Financial

Okay, thank you.

Operator

We will take our next question from Andrew Morrey, from Cohen Asset Management.

Andrew Morrey - Cohen Asset Management

Hi, what were your marketable homes passed, at the quarter end? I did not hear that.

Unidentified Company Representative

Hang on; just a second and we will look that up for you.

Andrew Morrey - Cohen Asset Management

I have one other question, while you look that up. You mentioned a little bit of the mix shift accounting for the RPU for HRT2, at $51. Can you remind us, again, when you generally like to take price increases, on a gross basis, and then roughly speaking, what you would think in terms of net? Do you think because of the mix shift, maybe this is more of a year where that should be more flattish, as opposed to up 2 or 3%?

Unidentified Company Representative

Andrew, the answer to your first question is that we were slightly over 919,000 homes passed, marketable homes passed.

Unidentified Company Representative

The answer to your second question is we generally take our price increases during the first quarter of a year. I think, in most of our markets, we have already communicated with the customers and we should begin to see some positive effect in the February and March time frame, of our price increases. As far as the percentage increases, I don't see us backing off terribly, in terms of what we have historically shown as price increases. Bret, are we still overall in the 5% range?

Bret McCants

Yes

Unidentified Company Representative

I do not see us going back down; based on what we already have out there. One of the things we focus on is how we package our triple play and double play products. We have various levels at which we package things. People can buy in at whatever level they choose, but we try to structure a package where we protect and maintain our gross margin structure when we do that.

Andrew Morrey - Cohen Asset Management

Okay, and my last question – when you mention the Huntsville example of the fill in investment from earlier, last year rather, can you talk about – are you able get a handle on; if you go and build out these 400 or 500 homes in one specific area, how do you have the extra confidence that you are going to get a couple hundred RGUs out of that? Are you able to do some form of selling or marketing, in advance of that to kind of circle what you would be able to gain there?

Unidentified Company Representative

Absolutely, we can do some premarketing. By definition, the fill in is within our geographical footprint. All of the media and marketing we do; they have heard, in many cases for years, so they know who we are; we just haven't been available to them. In a lot of cases, we just show up with a truck and they are knocking on our door asking, "When can we sign up". We do a little bit of both. We do some premarketing, but just being there and knowing we are coming to the neighborhood, allows us to do a lot of presales before we actually do the construction.

Unidentified Company Representative

Andrew, what happens, a lot of times these customers who have been living in a monopoly environment for a long time, they are ecstatically happy to have a choice. We provide them with a choice. That method that has been out there, for quite some time, we see a lot of people jumping over to our side of the table just because they have the opportunity to.

Andrew Morrey - Cohen Asset Management

Okay, thanks a lot.

Unidentified Company Representative

You are welcome. If there are not any more questions, we have time for one more.

Operator

We will take our final question from Amy Bloom of Stanfield.

Amy Bloom – Stanfield

Hi, I think you mentioned it, earlier in the call, you noted the KIA plant opened. I am just wondering if that is the case and if you have seen the growth you had expected there?

Rodger L. Johnson

Amy, it has not opened, yet. They are planning to open late this year, in 2009, and roll their first car off the assembly line –I think the mass production schedule really kicks in at the beginning of 2010, but they are going to open this year. The thing we are excited about is they are so far along in the construction that – we have been getting minor orders from the construction crews and their construction trailers and what have you – now we are getting orders that will be used to run the systems at the Kia plant. I know, last month I think I saw one that was $8,000 a month and one that was $16,000 a month, and another one that was $5,000 a month. We are starting to see a little momentum in terms of the lines they are signing up for.

Unidentified Company Representative

In addition, Rodger, we have all of the ancillary plants and manufacturers associated with them, that are coming online, as well. We not only see the benefits of KIA, but also the other plants that are associated with producing products for KIA.

Rodger L. Johnson

That is a great point. There are a lot of supplier companies that are being built, all up and down the highway here, in our territory. We will get the business out of those folks, as well. With that, guys, we have been at this for an hour. I know I do not want to keep you all tied up. If anybody has any individual questions, please feel free either to call Todd or Bruce or myself, after the call. We appreciate your interest and support. We feel like it was a good closeout to 2008, and we are excited about starting 2009. Thank you for joining us.

(Operator Instructions)

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Source: Knology, Inc. Q4 2008 Earnings Call Transcript
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